To trade or not to trade - what to do if your company gets into financial difficulties

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In these fraught economic times, many companies face an uncertain future. A number of recent court cases highlight the issues directors face when their company gets into financial difficulties. In this update, we contrast two recent decisions on wrongful trading and consider two further cases, one involving the disqualification of directors for not paying the tax man and one where directors were held to be personally liable to one of the company's creditors.

Wrongful trading

Wrongful trading occurs when a director knows, or ought to conclude, that there is no reasonable prospect of the company avoiding insolvent liquidation and does not take every step he ought to take with a view to minimising the potential loss to creditors.

The facts which any individual director ought to know or find out, the conclusions he should reach and the steps he ought to take are assessed taking into account both the general knowledge, skill and experience which would reasonably be expected of a director carrying out that director's role in relation to the company, and the general knowledge, skill and experience which the individual director actually has. So, for example, a finance director will be expected to have a certain level of competence in that area and will be judged accordingly, and a sales director who happens to have financial qualifications will also be expected to apply that knowledge.

Once a company has gone into insolvent liquidation, if creditors have suffered as a result of a director engaging in wrongful trading, the liquidator can apply to the court for a declaration that the director must personally contribute to the company's assets.

In March 2011, the directors of Idessa (UK) Ltd were ordered to contribute more than £1 million to the assets of the company. But in October, the directors of Langreen Ltd were cleared of wrongful trading. Why did the courts reach different conclusions in these cases?

Idessa was formed in October 2002 and was involved in the development of electronic tools for use in electoral registration and electronic voting. It was compulsorily wound up in November 2007 following a petition presented by a creditor, and the company's liquidator alleged the directors knew or ought to have concluded by June 2005 that there was no reasonable prospect of avoiding insolvent liquidation.

The judge accepted Idessa was a start-up company and it might therefore take some time before it made a profit. He also accepted substantial investment had been made into the company. However, it was clear that external investment had dried up by August 2005. Thereafter, whilst there was evidence of some trading income being generated, it was at nothing like the level required to make significant reductions in the overall deficit. In addition, a significant contract had been lost.

The judge concluded that the directors should, by the end of June 2005 (or so shortly thereafter as to make little difference), have concluded there was no reasonable prospect of avoiding insolvent liquidation. He also found they had not taken every step they ought to have taken to minimise the potential loss to creditors. On the contrary, they continued to use the company's money in much the same way as they had done previously, including paying themselves the same salary and incurring the same expenses as before. There was no "tightening" of the corporate belt and no evidence that the directors gave any thought at all to the creditors or the impact on them of the company continuing to trade. The directors were therefore guilty of wrongful trading.

Langreen started trading in March 2004, offering broadband services using satellite technology. This was not an easy market and the company struggled to find external finance. In December 2005, the company sought the advice of insolvency practitioners but decided to persevere. But in January 2006, the company's satellite provider terminated their connection, it was not possible to source a new supplier and the decision was made to cease trading. The company went into creditors' voluntary liquidation.

The liquidator brought wrongful trading claims against the directors alleging that on four separate dates the directors should have concluded that Langreen could not avoid insolvent liquidation. But the court, despite noting the company was always undercapitalised and always had cash-flow problems, said that on each of the relevant dates it could be understood why the directors had acted as they did. Their decisions to carry on trading were objectively reasonable, and had been taken in the interests of the creditors and investors. The wrongful trading claims against them were dismissed.

In contrast to the directors of Idessa, the Langreen directors had taken active steps to try to secure external investment and to manage debt, and were exploring new business opportunities. They were clearly aware of the company's financial position throughout, sought appropriate advice and had themselves ultimately taken the decision to cease trading.

Director disqualification for non-payment of taxes

The court can disqualify someone from acting as a director if his company becomes insolvent and his conduct as a director makes him unfit to be concerned in the management of a company.

In November, two directors of Janus Technologies Ltd had their appeals against disqualification rejected. The single allegation of misconduct against them was that they had not paid PAYE and NIC to HM Revenue and Customs (HMRC), although they had paid other creditors.

The judge set out the following principles in relation to non-payment of taxes:

Crown debts are not in a special category of their own. The issue is whether the directors took unfair advantage of forbearance on the part of a creditor, whether the Crown or anyone else.

A policy of non-payment which is required for the finding of misconduct may be conscious or subconscious.

Neither an intention to pay the debts in the long term, nor acting in good faith, provides an excuse which will prevent disqualification.

The fact that directors are making payments to some creditors to keep the business trading does not, of itself, excuse them.

The fact that directors may personally benefit while creditors are not being paid is an aggravating factor. Conversely, the fact that the directors make a loss themselves, or at least do not benefit, is again not of itself an excuse.

It is clear that a policy of non-payment for a relatively short period will suffice, and there appears to be no minimum period.

A failure by the Crown to exercise its draconian enforcement powers does not form any excuse for the conduct of the directors.

A failure to inform a creditor of the position with a view to reaching agreement for non-payment is a highly relevant matter.

This last aspect was particularly relevant in this case. The directors' defence relied on the fact that they had kept HMRC appropriately informed with a view to agreeing to defer payment. However, there were inaccuracies in their correspondence with HMRC including, in particular, a misleading statement that the directors had not drawn their salaries. The judge also found that the directors had not informed HMRC of a new contract and the revenue it would generate. In short, HMRC were never given a wholly accurate informed opportunity to make a decision whether or not to pursue payment, so the policy of paying other creditors but not HMRC was unfair and amounted to misconduct.

Personal liability for deceiving creditor

In October, two directors of Titan Marquees Ltd were found to be personally liable to one of the company's creditors, Roder UK Ltd.

Titan had agreed a payment plan with Roder, but regular payments under the plan had stopped. One of the directors told Roder that Titan was expecting an insurance payout, following which it would be able to resume payments. He knew this to be false. On a later occasion, the other director told Roder that Titan was selling up and that everyone would be paid in full from the proceeds of sale. The judge found that this statement was made recklessly without regard to the likelihood of Titan being, in fact, able to repay its creditors.

Because of these statements, Roder refrained from taking action to recover its debt, and lost the opportunity to do so when Titan ceased trading. The directors were found to be personally liable in deceit.

The Court of Appeal held, resolving longstanding uncertainty in English law, that such statements, intended to procure continuing credit for a third person (in this case, the company), do not have to be in writing if they are to form the basis for legal action.

Avoiding liability

These cases illustrate some of the perils facing directors when insolvency threatens. They show how essential it is for directors to keep a close eye on the company's financial position, to consider the interests of creditors and to be open and honest when seeking further time to pay. Judging when to persevere in the anticipation of trading out of the company's difficulties, and when to cease trading, can be extremely difficult and directors face potential personal liability and/or disqualification. With the stakes so high, it is vital that directors seek appropriate advice at the earliest opportunity.

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This briefing is written as a general guide only. It is not intended to contain definitive legal advice which should be sought as appropriate in relation to any particular matter.